Basic EPS vs. Diluted EPS

From time to time we have been asked what the difference between basic earnings per share (EPS) and diluted EPS is. This article attempts to explain the difference between the two and how they are calculated.

Basic EPS simply put is the EPS which accrues to the shareholders of the company. This is derived by dividing the net profit (after deducting dividend on preference shares) of a company by the total number of shares outstanding. So if the net profit of a company is Rs 100,000 and the shares outstanding are 2,000 the EPS of the company is Rs 100,000 / 2,000 = Rs 50.

Moving to diluted EPS which is a little more complicated than basic EPS. First we will talk about why diluted EPS is important when evaluating companies. Assuming a company needs to raise debt and it realises that it would be able to get cheaper debt by issuing convertible bonds rather than plain vanilla bond or it decides to reward its employees with stock options instead of bonuses. In these cases, when the convertible bond is converted or stock option is purchased, it will result in increase in number of shares for the company. For existing shareholders this will result in a lower EPS accruing to them. So a diluted EPS gives what the EPS of a company would be if all convertible bonds, convertible warrants, convertible preference shares and stock options outstanding on the company’s books are converted into shares. This will give the equity share holder the correct picture when investing in the company.

Hence diluted EPS = net profit ÷ number of shares adjusted for future dilutions.

However, there are certain points to be noted when calculating diluted EPS.

Firstly, when accounting for convertible bonds, after tax interest expense is not considered an interest expense for diluted EPS. Hence interest adjusted for tax should be added back to the net profit.

Secondly, in case of convertible preference shares, the dividend has to be added back to the net profit.

So the next time you are trying to figure out if a stock is cheap by calculating its price to earnings ratio (PE ratio) make sure that the denominator is diluted EPS.

Happy Investing!